The UK might be headed towards a recession as stubborn core inflation could see the Bank of England (BoE) increase interest rates to a peak of 5.5%.
Though down from 10.1%, inflation remained stubbornly high at 8.7% in April, with core inflation at its highest since 1992 and food prices rising alarmingly quickly.
Core inflation — which excludes energy, food, alcohol and tobacco — actually rose by 6.8% in the 12 months to April 2023, up from 6.2% in March, which is the highest rate since March 1992. This is a closely watched measure by the BoE when deciding interest rates.
Luke Hickmore, investment director at asset manager Abrdn, said the “real surprise” of rising core inflation in Britain’s economy would force the BoE into action on interest rates.
This in turn will lead to surging mortgage costs, which will put people’s incomes “under a lot of pressure”, he warned.
Read more: Interest rates: Markets expect a hike as UK ‘core inflation’ remains stubbornly high
Markets are pricing in that the BoE could raise rates as high as 5.5% by the end of the year, which has suppressed bond prices and sent the cost of government borrowing surging.
Chancellor Jeremy Hunt has backed interest rate increases being used to calm soaring inflation even if they increase the risk of pushing the UK into recession.
Hunt told Sky News that the “only path to sustainable growth” is to bring down the high prices behind the cost of living crisis.
Asked whether he was comfortable with the BoE doing whatever was needed to bring down inflation, even if that could cause a recession, Hunt said: “Yes, because in the end, inflation is a source of instability.”
“If we want to have prosperity, if we want to grow the economy, if we want to reduce the risk of recession, we have to support the Bank of England in the difficult decisions that they take.”
The government has pledged to halve inflation by the end of the year, which would mean CPI inflation dropping to 5% from over 10% at the start of 2023. That target is beginning to look like a stretch, after inflation fell by less than expected in April.
What is a recession?
Usually, when a country’s output is growing, the value of the goods and services it produces — known as its gross domestic product (GDP) — goes up. But during an economic downturn this value falls.
A recession is a period of negative economic growth for two consecutive quarters. It is when GDP drops for two three-month periods in a row, and comes as a sign that the economy is weakening.
Read more: Interest rates may rise despite inflation falling, says Bank of England’s Bailey
The International Monetary Fund this week said it no longer expected Britain’s economy to fall into a recession this year.
After its annual healthcheck on the UK, the IMF upgraded its forecasts. It now expects UK GDP will rise by 0.4% this year, rather than shrink by 0.3% as it had expected back in April.
However, analysts say the IMF would not have sounded so optimistic on Tuesday, had it known that Wednesday’s inflation report would have been disappointing.
The BoE increased interest rates for the 12th time in a row earlier in May to its highest level in 15 years to 4.5%.
The move has been made to cool down the demand for labour and place upward pressure on pay.
By raising interest rates, the theory is that people spend less, demand goes down and then this should mean inflation drops. But mortgages rates are usually linked to interest rates, meaning those who are not on a fixed-rate mortgage face steep increases to their monthly repayments.
Raj Badiani, principal economist at S&P Global Market Intelligence, said: “Rising service and core inflation in April suggests the Bank of England has little option but to continue its current tightening cycle.
“We now expect the policy rate to rise by 25 basis points to 4.75% at its next meeting on 22 June while acknowledging the rising probability of a further hike in early August.”
UK inflation dropped to 8.7% in April as the measure of price rises slips out of double digit figures for the first time since last summer but high food prices persist.
The sharp drop is due to the fact energy price rises are slowing from the extreme hikes seen a year ago.
Read more: How rising interest rates will impact your mortgage and savings
However, it does not mean prices are coming down, only that they are rising less quickly.
City economists had forecast a bigger decline to 8.2%, helped by last year’s rise in household gas and electricity bills dropping out of the annual calculation for the increase in living costs.
The ONS said: “The easing in the annual inflation rate in April 2023 mainly reflected price changes in the housing and household services division, particularly for gas and electricity.
“This was offset partially by upward effects coming from recreation and culture, alcoholic beverages and tobacco, communication, and transport.”
The BoE believes that inflation has “turned the corner” and is on its way down.
Governor Andrew Bailey said annual inflation was on track to fall sharply in the face of a recent drop in wholesale energy prices, coupled with the prospect of last year’s jump in gas and electricity bills for British households dropping out of the annual figure.
Speaking before the release of official inflation figures for April on Wednesday morning, Bailey told MPs on the Commons Treasury committee: “I do stand by the view that it has turned the corner.”
Read more: Inflation: The supermarket items that have gone up in price the most
Government borrowing costs have surged since data on Wednesday showed core inflation in the UK economy, which strips out volatile food and energy prices, increased to its highest level in 31 years to 6.8% in April.
Hickmore told BBC Radio 4’s Today programme: “This higher interest rate profile from the Bank of England, higher mortgage rates and still high inflation it is going to be increasingly hard to avoid a recession.
“I don’t think it will be a really hard recession but we will feel it and people’s incomes are going to come under a lot of pressure from those higher mortgage rates.”
Hickmore said he feared recession at the end of this, or the start of next year.
Watch: How does inflation affect interest rates?
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